Recent trends in financial markets since the UK voted to the leave the EU have been odd, to say the least. 
First and foremost, despite the potential negative and well publicised ramifications of Brexit, the FTSE 100 has rallied significantly (it is up some 10 per cent since the vote) and is nearing the psychological 7,000 barrier at a rate of knots.
The drivers behind this rally have been well-documented. Currency has certainly played its part, as the pound’s 10 per cent correction versus the likes of the US dollar and the euro has acted as a major boon to the index’s large proportion of overseas earners.
There has also been support from the Bank of England, with the MPC voting to halve interest rates to 0.25 per cent and flood the market with further quantitative easing (a programme which now includes the purchase of corporate debt).
Seasonal trends have had an effect as well, with thinner trading volumes during the month of August amplifying market moves.
All this would suggest euphoric times for UK fund managers – but this is where the ‘odd’ part of recent market dynamics comes in.
Firstly, it seems many active managers in the open-ended space don’t believe this rally is going to last.
Performance of index and average cash weighting in open-ended UK funds
Source: FE Analytics
FE data shows, for instance, that the average cash weighting across the IA UK All Companies and IA UK Equity Income sectors has doubled since the EU referendum to more than 6 per cent – suggesting most are ‘keeping their powder dry’ in the hope that better value opportunities will arise over the coming weeks.
What’s even more surprising, however, is what has happened in the world for investment trusts – especially in the UK equity income space.
In a world where the market is soaring, interest rates are at their new lowest ever level meaning the search for yield has only intensified and (due to currency effects) inflation is returning, it seems very strange that few investors – in a historical context – appear to be buying trusts in the IT UK Equity Income sector.
Indeed, despite an average yield of 4.32 per cent (which is some 370 basis points more than you can get from a 10-year UK gilt at the moment), some 73.1 per cent of the sector’s members are trading on wider discounts than their three-year average, according to data from the AIC.
This widening effect has had significant implications for investors’ total returns.
According to FE Analytics, the IT UK Equity Income sector average has returned 3.16 per cent over the year-to-date compared with an 11.90 per cent gain from the FTSE All Share. That is because just four (or 15 per cent) of trusts in the peer group are beating the index in 2016 so far.
Performance of sector versus index in 2016
Source: FE Analytics
It’s a similar story when looking at the performance of investment trusts relative to the index since the EU referendum itself – like in the open-ended universe.
So why has this trend emerged?
Winterflood’s Innes Urquhart notes that discounts were generally narrowing prior to the referendum due concerns surrounding Brexit and that, while they have recovered somewhat since the vote, the sheer weight of outflows for open-ended UK equity funds over recent months has also clearly had an effect.
It is also worth noting that UK trusts are structurally overweight mid-caps relative to the FTSE All Share (which isn’t surprising given the FTSE All Share is 80 per cent weighted to the FTSE 100).
Mid-caps have had the toughest time of it over recent months as they are deemed to be more domestically-orientated than large-caps. As such, not only have there been concerns about the impact Brexit will have on the UK economy (and therefore FTSE 250 stocks’ earnings) but mid-caps haven’t received the currency boost that many FTSE 100 companies have over recent months.
Indeed, FE data shows the FTSE 250 index has only made 4.01 per cent over the year-to-date and 3.11 per cent since the referendum.
As such, it makes sense that the IT UK Equity Income sector’s best performers (and those trading on the narrowest discounts) are those with a large-cap bias and preference for international earners like The City of London IT, F&C Capital & Income IT, Finsbury Growth and Income and Troy Income & Growth – though the latter does implement a zero discount control policy.
Looking at the other end of the spectrum and, within the list of trusts with the widest discounts in the peer group, a number of them are those tend to be those with the highest weightings to smaller companies.
These include Dunedin Income Growth and the Lowland Investment Company.
The UK equity income trusts on the widest discounts to NAV
Source: The AIC
Though many investors may be confused by the recent market dynamics, especially as there are signals that a market correction is on its way given volatility (as measured by the VIX index) recently reached its lowest level in two years suggesting a degree of complacency among investors, Winterflood believes some opportunities have arisen within the sector.
In particular, Urquhart and his team are currently recommending Alastair Mundy’s Temple Bar Investment Trust and Mark Barnett’s Perpetual Income & Growth Trust, which are trading on discounts of 8.2 per cent and 6.15 per cent, respectively.
Mundy’s trust is highly value-orientated, a strategy that hasn’t suited market conditions. His contrarian investment style has led a portfolio including Lloyds, Royal Bank of Scotland and Morrisons.
As a result, the trust has underperformed relative to the FTSE All Share so far this year – as it did in 2014 and 2015. However, Urquhart rates Mundy’s approach for the long-term investor and says at this levels, an attractive buying opportunity has emerged.
“We believe that there is much merit in Alastair Mundy's contrarian approach, particularly for long‐term investors,” Winterflood said.
Performance of trust versus sector and index under Mundy
Source: FE Analytics
Despite its long-term track record under Barnett, Perpetual Income & Growth’s discount has widened considerably this year meaning the trust has lost more than 5 per cent since January.
What is strange though is, thanks to the manager’s preference for high quality businesses with visibility of earnings and healthy balance sheets, the trust’s largest positions are in international facing large-caps (indeed its top 10 even includes stocks listed outside of the UK) and therefore the trust should have benefitted from currency weakness.
However, its overweight position in mid-caps has seemingly weighed on sentiment towards Perpetual Income & Growth.
